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ETFs

This ETF Offers Low-Cost Exposure to Developing Economies

Capturing the evolving composition of the emerging-markets universe.

The emerging-markets universe is more dynamic than developed markets like the United States. The country and sector composition of these markets change at a much greater pace as their underlying economies grow and develop. But gaining access to that growth comes at a cost, as these stocks are also more difficult and expensive to trade than those listed in developed economies. Thus, a low-cost index fund like iShares Core MSCI Emerging Markets ETF IEMG can be a great option. Its market-cap-weighted approach cuts back on turnover and related trading costs while capturing the evolving composition of these markets. It earns a Morningstar Analyst Rating of Bronze.

IEMG tracks the MSCI Emerging Markets Investable Market Index, which includes stocks of all sizes from 24 emerging-markets countries. Its market-cap-weighted approach benefits investors by capturing the market’s collective opinion of each stock’s value while mitigating turnover and trading costs. Markets usually get long-term prices correct, but they occasionally make mistakes. Investors can drive valuations up if they get excited about a particular area of the market, and market-cap weighting will increase the fund’s exposure to it.

The portfolio’s broad reach helps mitigate the impact of the worst-performing stocks. It holds more than 2,200 names, while its 10 largest positions account for only 22% of its assets. It also provides greater exposure to a narrow segment of the emerging-markets universe. Up until several years ago, locally traded China A-shares were difficult for retail investors to hold owing to restrictions imposed by the Chinese government. But these restrictions have loosened over time, and the fund had just under 1% of its assets in China A-shares as of February 2019.

Differences in country composition can cause the fund’s performance to deviate from its peers. Stocks listed in China make up just under a third of the portfolio, compared with 26% for the category average.

The fund’s low expense ratio helped it beat the category average by 30 basis points annually from its launch in October 2012 through February 2019. However, its performance did not stand out within the category. Many of its better-performing competitors had a growth tilt and used stock selection to improve their returns. The fund’s 0.14% expense ratio ranks as one of the lowest in its category and should continue to provide a reliable long-term advantage.

Fundamental View Stocks listed in emerging markets account for approximately 7% of total global market capitalization. Despite their small position in global markets, they can provide investors with a broader selection of publicly traded stocks and can better diversify a portfolio of those listed in the U.S. compared with other developed markets. The historic 10-year correlation of this fund's benchmark with the Russell 3000 Index was 0.76 through February 2019. A developed-markets index like the MSCI World Ex USA Investable Market Index had a correlation of 0.87 with the Russell 3000 Index over the same period.

In addition to their diversification advantage, the economies of emerging markets often enjoy strong economic growth. But this doesn’t necessarily translate into strong market returns. The stocks listed on emerging-markets exchanges often have operations that span a range of countries and regions. Therefore, they don’t provide clean exposure to the local economies of developing nations.

Market-cap-weighted funds like this one provide investors with cost-efficient, diversified access to the opportunity set that active managers select from and make no active bets on specific regions, countries, sectors, or individual stocks. This approach essentially free-rides on the collective opinions of active investors. The weight of a given stock, country, or sector will stem from the collective opinions of these investors. As a result, this methodology naturally emphasizes companies that are large and stable while underweighting those that are smaller and more volatile.

Diversification and market-cap-weighting are certainly beneficial characteristics, but stocks listed in emerging markets also carry some unique risks. Some of these companies are partially owned by sovereign governments. This can expose investors to a certain level of political risk because governments can put their political interests before those of public shareholders. Additionally, many of these developing nations do not have the infrastructure and mature legal systems that are more common in developed markets like the U.S. and Europe. This can increase both the cost and difficulty of conducting business in these countries.

Stocks listed in China present an additional risk to this fund in the form of country concentration. As of February 2019, they accounted just under a third of this fund’s assets. Their fraction of the emerging-markets universe will likely continue to grow and erode this fund’s geographic diversification as China A-shares become more accessible to foreign investors. This fund already includes China A-shares in its portfolio.

Like many of its competitors, this fund does not hedge its currency risk. It has considerable exposure currencies like the Chinese renminbi, Indian rupee, and Brazilian real. So, exchange-rate fluctuations can add to the fund’s volatility.

Portfolio Construction The portfolio's construction process reasonably represents stocks from emerging markets, but it does not take measures to promote regional diversification. It earns a Neutral Process Pillar rating.

The managers use a statistical sampling approach to track the MSCI Emerging Markets IMI, which covers 24 emerging markets. This benchmark sorts stocks by their free-float-adjusted market cap and holds those that rank in the top 99% by market cap. The process uses buffering rules around this cutoff point to help mitigate excessive turnover and applies additional liquidity screens that help make the final index easier to track. The index weights its holdings by market cap, which helps mitigate turnover and any related trading costs. It rebalances semiannually in May and November. The fund holds nearly all of the large-cap stocks included in this benchmark, and the managers select a representative sample of the small-cap segment to replicate its performance. This technique reduces the need to trade small-cap stocks, which can be less liquid and more expensive to transact.

Fees BlackRock charges one of the lowest expense ratios in the diversified emerging-markets Morningstar Category, so the fund earns a Positive Price Pillar rating. Its 0.14% expense ratio is cheaper than all but a few of its competitors. The fund's total returns have mildly beat its target index by 0.06% annually over the trailing three years through February 2019. This advantage was a result of the fund's securities-lending revenue and its statistical sampling approach, which reduces the need to hold small-cap stocks that can be expensive to trade. Long-term investors should not rely on this modest advantage to persist over the long run.

Alternatives Vanguard FTSE Emerging Markets ETF VWO (0.12% expense ratio) is a close competitor with a slightly lower expense ratio. Like IEMG, it covers large-, mid-, and small-cap stocks, weights holdings by market cap, and earns a Bronze rating. However, its country composition looks slightly different. It excludes stocks from South Korea, while IEMG has a 14% stake in that market. VWO also has a higher 4% allocation to China A-shares.

Bronze-rated Schwab Emerging Markets Equity ETF SCHE (0.13% expense ratio) also provides low-cost, diversified, cap-weighted exposure to stocks listed in emerging markets. It is focused on large- and mid-cap stocks, making it modestly less diversified than VWO and IEMG.

Investors who want exposure to emerging markets but desire less risk might consider Silver-rated iShares Edge MSCI Minimum Volatility Emerging Markets ETF EEMV (0.25% expense ratio). It covers the same countries as IEMG but selects and weights its holdings using an optimizer that attempts to minimize expected volatility. This methodology also constrains its holdings to have sector and country weightings that are comparable to the MSCI Emerging Markets Index, so it suffers from the same country concentration as VWO and IEMG.

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